Now It’s a ‘Leading’ Question

The stock market is so flush with gains this year that investors now find themselves quibbling not so much over whether the market is going up or down, but whether it’ll be “big” stocks or “little” stocks that do even better in the fourth quarter.

Much of the market’s advance this year initially was on the shoulders of the so-called big-capitalization stocks, those widely held favorites that include the market’s blue chips, glamour stocks and the 500 stocks in the Standard & Poor’s composite index.

This summer, though, the “small-cap” or “emerging growth” stocks--those of smaller companies that are often less widely held, more thinly traded and, in many cases, simply more speculative--staged a rally that pushed the bigger stocks off center stage.

Since May 1, the Russell 2,000 index of mostly smaller issues has jumped 30%, while the S&P; 500 has gained 18%. And since Aug. 1, the Russell 2,000 is up 8%, while the S&P; 500 is virtually unchanged.

Among the market’s most familiar names, General Electric Co. (ticker symbol: GE) is off 5% since Aug. 1, American Express Co. (AXP) has slipped 2%, Coca-Cola Co. (KO) is down 9% and Philip Morris Cos. (MO) has dropped 7%.

For the year so far, however, the vast majority of stock indexes are sporting gains of 20% or more, signaling yet another banner year for the market overall.

If the market maintains its pace through the final quarter, it means stocks will have once again done more than twice as well as normal, which is a 10% annual gain by historical standards.

Many on Wall Street are convinced that the smaller stocks will continue to thrive in the fourth quarter, because the factors that propelled them higher this summer--and caused the big-cap stocks to pull back--remain in place.

But others are just as convinced that the big-cap stocks will again dominate, in good part because their recent price drops have again made them especially appealing to investors.

That such a debate is even occurring probably makes some investors nervous. It smacks of complacency, of an assuredness that stocks generally will keep rising--just the kind of excessive optimism, or what wags sometimes call market frothiness--that can lead to a rude correction.

After all, if the market maintains this pace, stocks (as measured by the S&P; 500) will record their third straight year of gaining 20% or more, a blistering pace that makes the question of “How long can it last?” even more pressing.

It’s hard not to be optimistic, though, because most of the economic conditions that have driven stocks higher up to this point--a moderately growing economy, low inflation, low interest rates--are still in place.

(The Federal Reserve Board’s policymaking arm is scheduled to meet today, but many observers don’t see the group being overly worried about inflation and therefore seeing a need to lift short-term interest rates.)

But there are still trouble spots in the economic outlook that could give the market fits in the months ahead, said A. Gary Shilling, who heads an investment firm bearing his name in Springfield, N.J.

Consumers’ spending and their installment debt remain very high and could be due for a slowdown, and organized labor (as in the recent strike against United Parcel Service of America) is pressing for higher wages, which could fan inflationary pressures, he said. That could prompt the Fed to raise interest rates before long. Also, the U.S. dollar remains strong against other major currencies, which is narrowing profit margins for many U.S. multinationals and exporters.

Bull markets historically end over “a matter of months, not with a bang,” and a merging of these events and other economic disruptions could do the trick, Shilling said.

For now, there are plenty of analysts contending the whole argument about big caps versus small caps is moot, that what really matters is whether certain companies--regardless of their size or how many shares they have outstanding--will keep increasing their profits to support higher stock prices.

“That’s going to be the focus, not what group the company happens to be in,” said Alfred Goldman, market strategist at A.G. Edwards & Sons Inc. in St. Louis. “If a company can grow its earnings, investment dollars will chase it.”

That was evident in the third quarter. Setting aside the issue of size for a moment, companies with stellar earnings growth continued to outpace the general market. They included securities brokers and other financial institutions (still benefiting from the bull market, low interest rates and a rush of mergers), computer and semiconductor makers, and airlines and other transportation concerns.

Conversely, companies with meager profit gains (and whose outlooks were very much muddled) continued to suffer, such as utilities and gold- and silver-mining stocks. Real estate investment trusts also lagged during much of the quarter, although they’ve picked up steam again in recent weeks (see accompanying chart).

And with the market still near a record high, companies of any stripe that announce disappointing earnings are being quickly punished by investors.

Indeed, the big-cap stocks have struggled lately because their earnings growth has slowed. After bidding the stocks sharply higher--Gillette Co. (G) at one point was trading for nearly 50 times its expected 1997 profit--that’s not what investors wanted to hear, so they sold off (Gillette included).

The multinationals and major exporters in particular saw profit growth ease because of the U.S. dollar’s growing strength. Some analysts see that trend continuing, giving further strength to small-cap issues that operate mainly in the domestic economy.

“The argument can be made, at least today, that the earnings growth is a lot better at smaller companies relative to larger company,” said David Diamond, senior vice president at Boston Co., an investment unit of Mellon Bank.

But the small-cap universe is, well, big. So which stocks are worth a look?

Diamond’s picks include companies he sees benefiting from California’s economic resurgence, including concrete maker CalMat Co. (CZM) and real estate developer Catellus Development Corp. (CDX).

Also on his list are some specialty retailers that have struggled but still show promise, including apparel retailers Talbots Inc. (TLB) and Gymboree Corp. (GYMB).

L. Keith Mullins, emerging-growth stock specialist at Smith Barney Inc., said there’s another reason the small-cap sector should get a boost in the fourth quarter: the recent problems of small overseas stock markets, especially in Southeast Asia.

Frustrated investors who had put cash into mutual funds investing in those markets are now diverting that money back to small-cap stocks in the U.S. market, he said.

“This is money looking for risk, and it’s going domestic again,” Mullins said.

Mullins’ picks also focus on consumer-service stocks, because, he believes, it’s easier to forecast profit growth for those firms than it is for small and mid-size manufacturers.

“It’s especially hard to predict the earnings of technology manufacturers,” he said.

So, he likes Hibbett Sporting Goods Inc. (HIBB), a chain based in Birmingham, Ala. Among larger companies, Mullins recommends office-product retailer Staples Inc. (SPLS) and computer retailer CompUSA Inc. (CPU). Paychex Inc. (PAYX), the payroll-processing concern, is also on his list.

Service stocks are also popular with Douglas Cliggott, chief investment strategist at J.P. Morgan Securities Inc., even though his favorites include lots of big-capitalization companies.

Why? They’re relatively cheap, for one thing, and they’re largely immune from the havoc the dollar is playing on the profits of big U.S. manufacturing exporters and multinationals.

His firm is fond of major regional telephone companies, for instance, and of selected nursing-home operators, restaurants and media companies.

“In the case of these companies, the lion’s share of their revenues and earnings are generated in the United States,” he said.

Bell Atlantic Corp. (BEL), BellSouth (BLS) and SBC Communications Inc. (SBC) are on its “buy” list of telephone companies. In the restaurant sector, Cliggott said prices are going up, and “the trend in restaurant sales is sloping upward.” And his firm likes Apple South Inc. (APSO), which runs 400 outlets.

Speaking of restaurant chains with “apple” in their names, Applebee’s International Inc. (APPB) is being recommended by A.G. Edwards’ Goldman as an alternative to chasing the big industrial or glamour stocks that had soared in price but might now disappoint if the economy loses steam or their earnings growth falters.

“There’s growing anticipation that the economy in 1998 will slow down a bit, and if it does, that means your consumer nondurables [such as apparel] and defensive stocks [such as restaurants] should have easier going than the heavy industrial stocks,” Goldman said.

Using that reasoning, Goldman favors Cypress Semiconductor Corp. (CY); Atmel Corp. (ATML), another maker of computer chips; and golf equipment maker Callaway Golf Co. (ELY), a once-highflying stock that’s since checked up, gaining a paltry 5% over the last 12 months.

Make no mistake, though: Investors haven’t turned their backs on the market’s biggest stocks. But after climbing so high, those stocks are now vulnerable to any pessimism about their prospects, so the trick is finding companies that are expected to be steady performers.

“This is a mature bull market,” Goldman said. “So the market becomes more selective, a bit more difficult, and we all have to work harder and smarter.”

A good place to start is in the financial sector, where the downward trend in long-term interest rates (and thus their cost of obtaining long-term capital) keeps supporting the stocks.

That’s why Lehman Bros.’ recommended list includes such big financial players as insurer American International Group (AIG), financial services provider State Street Corp. (STT) and banker Citicorp (CCI).

Lehman analyst Tim Wallace also has a “buy” on Westinghouse Electric Corp. (WX), which is aggressively buying media properties, including its recent pact to acquire American Radio Systems (AFM) for $1.6 billion.

And there are some big technology stocks that, despite sizzling gains so far this year, are still being recommended by the likes of Oppenheimer & Co., whose “buy” list includes computer maker Compaq Computer Corp. (CPQ) and chip producer Advanced Micro Devices Inc. (AMD).

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How the Indexes Stack Up

Financial and high-technology indexes continued to show the market’s biggest gains through the first nine months of 1997, joined by transportation averages, which got a big boost in the third quarter. Here are some leading--and some lagging--major U.S. indexes and what they represent and their percentage changes, Jan. 1 through Friday:

PACESETTERS

Amex Broker/Dealer +72.1%

(12 major brokerages and investment bankers)

*

Lehman Select Technology +58.4

(23 high-technology issues)

*

Philadelphia Semiconductor +57.6

(16 chip-related stocks)

*

S&P; MidCap Transportation +53.4

(12 mid-size transportation concerns)

*

S&P; MidCap Financial +49.2

(35 mid-size financial institutions)

*

Amex Computer Technology +48.0

(26 computer stocks)

*

Dow Jones Transportation Average +40.2

(20 major transportation stocks)

*

Bloomberg Broadcasting & Cable +39.1

(66 broadcasting/cable issues)

*

S&P; MidCap Energy +36.6

(21 mid-size energy companies)

*

Amex Airline +36.6

(10 major airline companies)

LAGGARDS

Philadelphia Gold & Silver -12.4%

(11 gold/silver mining stocks)

*

S&P; SmallCap Communications -9.7

(5 small telecommunications issues)

*

Bloomberg Real Estate Investment Trust +2.4

(45 REIT stocks)

*

Dow Jones Utilities +3.0

(15 major utility operators)

*

Amex Natural Gas +4.8

(15 natural gas companies)

*

Amex Tobacco +7.6

(9 major tobacco stocks)

*

CBOE Gaming +8.1

(15 gaming/hotel issues)

*

S&P; SmallCap Health Care +12.7

(65 small-capitalization health-care stocks)

*

Morgan Stanley Commodity Related +14.1

(20 commodity issues)

*

Philadelphia Phone Sector +15.2

(6 major telephone service providers)

*

S&P; 500 + 27.6%

Amex: American Stock Exchange

CBOE: Chicago Board Options Exchange

S&P;: Standard & Poor’s

Source: Bloomberg News

*

Times staff writer James F. Peltz can be reached at james.peltz@latimes.com